Early signs of an economic recovery have brought back the classical dilemma faced by central banks: growth or price stability?
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India’s central bank faces this choice after a gap of nine months during which it cut its policy rate drastically from 9% to 3.25% and generated at least Rs5.6 trillion of liquidity through many measures to fight an unprecedented credit crunch and also lift a sagging economy.
Reserve Bank of India (RBI) governor D. Subbarao signalled the end of an expansionary policy regime by leaving key policy rates unchanged in the quarterly review of monetary policy on Tuesday. At the same time, he raised projections for both growth in India’s gross domestic product (GDP) as well as inflation.
The central bank has not given any firm commitment about revising its growth target for the current fiscal year; it remains at 6% with an “upward bias”. But it has raised the projected year-end inflation rate from 4% to 5%.
This means while RBI is cautiously optimistic about growth in India’s Rs54 trillion economy, it is concerned about the likely rise in inflation. In monetary parlance, RBI has shifted its policy stance from “dovish” to “neutral”, but if one reads between the lines it is not difficult to see the underlying theme of the review—the measure-less quarterly policy is just a way to buy time before RBI tightens its monetary policy. That could happen as early as September or as late as April, depending on the pace of economic recovery and the trajectory of price rise.
The benchmark wholesale price-based inflation rate declined for successive six weeks between June and mid-July, but RBI is concerned about the fact that there has not been any sharp decline in inflation expectations—a key to the stance of any monetary policy.
Also See Nuts and Bolts of RBI Policy Review (PDF)
The decline in inflation does not signify any demand contraction, but is a statistical illusion reflecting the higher base effect of last year. Wholesale price-based inflation peaked at 12.91% in August and the so-called base effect will completely wear off by October, and inflation is then likely to start creeping up.
Even though inflation of manufactured products is negative, that of manufactured food products is high and primary food prices, too, continue to rise on uncertain progress of the monsoon. Moreover retail prices, as measured by the Consumer Price Index have remained high.
These, combined with rising global commodity prices, will put pressure on inflation.
Another contributing factor to the rise in inflation could be the abundance of liquidity, as plenty of money stokes inflation.
So why isn’t RBI starting to withdraw liquidity and tighten policy to fight the likely rise of inflation right away? There are two reasons. First, the signs of economic recovery are positive, but RBI is not convinced yet about the pace of recovery. Second, it needs to manage the government’s massive Rs4.51 trillion annual borrowing programme to bridge the fiscal deficit of 6.8% of the gross domestic product (GDP) and yet ensure that individual and corporate borrowers are not denied money, as one key to the economic growth is expansion of bank credit for productive purposes.
Indeed, there are many signs of recovery. For instance, food stocks have increased; industrial production has gone up; corporate performance has improved on declining interest rates; and credit offtake is on the rise since end-June. But a delayed and insufficient monsoon, depressed consumer demand, rising food prices and a very high fiscal deficit are factors that can slow the pace of recovery.
So the biggest challenge before RBI at this juncture is managing excess liquidity in the system, at the same time keeping prices in check—a task that any central bank would love to hate.
On an average, RBI has been absorbing about Rs1.2 trillion from banks daily since April, but it is still not willing to tighten liquidity as banks will need the money to lend once demand picks up. Besides, it needs to make sure that the government is able to borrow from the market to bridge its fiscal deficit.
One key driving factor for economic recovery is low interest rates, but a very high government borrowing programme has already put pressure on rates. The yield on benchmark 10-year government bonds has risen from 5.8% in January to 7% towards the end of July.
Till now, the demand for money from the private sector is very low, but that has traditionally been the case in the first quarter of every fiscal year. Once demand picks up, RBI will find it difficult to maintain the low interest rate regime unless it allows liquidity to remain in the system even at the risk of stoking inflation. Which is why the policy document said RBI will maintain “policy rates and liquidity conditions conducive for revival of private credit demand”.
But if this statement gives one the impression that liquidity and low interest rates are here to stay forever, one is mistaken. RBI will withdraw the accommodative monetary policy at the first definite sign of economic recovery and a rise in inflation.
The message for the government is also very clear: It must return to the path of fiscal consolidation and bring down its deficit. The policy document has said M3, or money supply, growth has been 20% during the year, higher than RBI’s target of 17%, and a major source of the higher-than-projected growth in money supply has been the central bank’s bond purchases from the market. RBI has been buying bonds to generate liquidity and ensure a smooth progress of the government’s borrowing programme. This admission by governor Subbarao puts an end to the debate on monetization of the government’s deficit.
Whether the central bank prints money or sell bonds to generate liquidity, the impact on the system remains the same—expansion on money supply and pressure on inflation.
Monetary accommodation can manage fiscal profligacy in emergencies, but if the government makes it a habit, no central bank will be willing to carry the can for long.
Graphics by Paras Jain / Mint
Tamal Bandyopadhyay keeps a close eye on all things banking from his perch as Mint’s deputy managing editor in Mumbai Please email comments to email@example.com